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THE ECONOMIC OUTLOOK FOR 1979-1980: AN UPDATE The Congress of the United States Congressional Budget Office For sale by the Superintendent of Documents, U.S. Government Printing Office Washington, D.C. 20402

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THE ECONOMIC OUTLOOK FOR 1979-1980:

AN UPDATE

The Congress of the United StatesCongressional Budget Office

For sale by the Superintendent of Documents, U.S. Government Printing OfficeWashington, D.C. 20402

PREFACE

The Economic Outlook for 1979 and 1980; An Update is one of aseries of reports on the state of the economy issued periodicallyby the Congressional Budget O f f i c e . In accordance with CBO'smanda te to provide object ive analysis, the report contains norecommendat ions. The report was prepared by Joan Schneider,George Iden, Frank Russek, Steve Zeller, Lawrence DeMilner, NarimanBehravesh, Marvin Phaup, Yolanda Kodrzycki, Rebecca Shillingburg,Asa St rong, Toni Gibbons, John Jacobson, and Carl Gunn, underthe direction of William J. Beeman and James E. Annable. RobertL. Faherty and Francis S. Pierce edited the manuscript; MarshaMottesheard, Dorothy J. Kornegay, Judy Deason, and Debra Blagburntyped the many drafts .

Alice M. RivlinDirector

July 1979

iii

CONTENTS

PREFACE . ill

SUMMARY xi

CHAPTER I. CURRENT ECONOMIC DEVELOPMENTS 1

Prices and Wages « • 1Final Sales . 8Household Sector 9Business Sector 18International Sector ... 23State and Local Government Sector ... 23Employment and Unemployment ....... 26

CHAPTER II. POLICY DEVELOPMENTS AND THE ECONOMICOUTLOOK 31

Recent Policy Developments ....... 31The CBO Forecast • 38Implications for Fiscal Policy . . . . „ 45

TABLES

Page

TABLE 1. CATTLE INVENTORIES, 1970-1979: MILLIONSOF HEAD ON JANUARY 1 3

TABLE 2. OPEC PRICE OF OIL AND U.S. IMPORTS,1972-1979 4

TABLE 3. SELECTED WAGE MEASURES, 1978-1979:• PERCENT CHANGE 7

TABLE 4. CHANGES IN CONSTANT DOLLAR FINAL SALESAND ITS MAJOR COMPONENTS, 1976-1979:PERCENT CHANGE, AT ANNUAL RATES 8

TABLE 5. INCREASES IN CONSUMER PRICES FOR GASOLINE,DECEMBER 1978 - MAY 1979: PERCENT CHANGE,MONTHLY RATE 11

TABLE 6. CHANGES IN RETAIL SALES AND CONSUMERPRICES, SELECTED MARKET CATEGORIES:PERCENT CHANGE FROM DECEMBER 1978 TO MAY1979 13

TABLE 7. HOUSE-BUYING ATTITUDES, 1978-1979:PERCENT OF RESPONDENTS 14

TABLE 8. ANNUAL INCOME LEVEL NEEDED TO QUALIFYFOR MORTGAGE, 1977-1979: BY HALFYEARS 16

TABLE 9. MORTGAGE LOAN COMMITMENTS AND CLOSINGSAT SAVINGS AND LOAN ASSOCIATIONS,1978-1979: IN MILLIONS OF DOLLARS,QUARTERLY RATES 18

TABLE 10. BUSINESS FIXED INVESTMENT, 1975-1979:PERCENT CHANGE IN CONSTANT DOLLAR 19

TABLE 11. MANUFACTURING CAPACITY UTILIZATION,1978-1979: PERCENT, SEASONALLY ADJUSTED . . 21

VII

TABLES CONTINUED

TABLE 12. STATE AND LOCAL GOVERNMENT RECEIPTSAND EXPENDITURES, 1977-1979: IN BILLIONSOF DOLLARS, NIA BASIS, SEASONALLY ADJUSTEDANNUAL RATES 25

TABLE 13. FEDERAL BUDGET ESTIMATES UNDER CURRENTPOLICY ASSUMPTIONS, FISCAL YEARS 1978-1980: IN BILLIONS OF DOLLARS 32

TABLE 14.

TABLE 15.

TABLE 16.

TABLE 17.

FEDERAL DEFICITS AND FULL-EMPLOYMENTBUDGET MEASURES, FISCAL YEARS 1977-1980:IN BILLIONS OF DOLLARS, NIA BASIS . . ,

TRENDS IN THE GROWTH OF FEDERALSPENDING AND ITS COMPOSITION, FISCALYEARS 1976-1980: IN BILLIONS OFDOLLARS, NIA BASIS ,

INTEREST RATES AND ANNUAL GROWTH RATESOF SELECTED MONETARY AGGREGATES,CALENDAR YEARS 1976-1979

33

ECONOMIC PROJECTIONS BASED ON CURRENTPOLICY: CALENDAR YEARS 1979 AND1980

34

36

39

viii

FIGURES

FIGURE 1.

FIGURE 2 .

FIGURE 3 .

FIGURE 4 .

FIGURE 5.

FTGIIRF 6 .

FIGURE 7 •

FIGURE 8 .

FTGITRF 9 .

FIGURE 10.

PERCENT CHANGES IN THE CONSUMER PRICEINDEX AND SELECTED COMPONENTS

HOUSEHOLD SECTOR CONDITIONS

SALES OF DOMESTIC AUTOMOBILES

HOUSING SECTOR .....

NET SAVINGS INFLOW AT INSURED SAVINGSAND LOAN ASSOCIATIONS

BUSINESS SALES AND INVENTORIES

INTERNATIONAL SECTOR

LABOR MARKET CONDITIONS

CONSTRUCTION AND AUTOMOBILEINDUSTRIES

Page

2

10

12

15

17

20

22

24

27

28

ix

H8-096 0 - 7 9 - 2

SUMMARY

The sharp acceleration of inflation in 1978 and again in thefirst half of this year not only has caused real incomes to fallfor many people, but also has hastened the decline in the economy.The economic forecast prepared last January by the CongressionalBudget Office (CBO) projected continued high inflation in 1979 anda mild downturn in the economy in the second half of this year.The economic downturn was expected to result largely from twofactors. First, weaker consumer demand was forecast because of theerosion of purchasing power due to inflation and because of thelikelihood that rapid consumer sales in 1978 had borrowed fromfuture sales as consumers bought in anticipation of inflation.Second, a more restrictive monetary policy had been adopted lastfall in response to inflation and the depreciation of the dollar ininternational markets.

Since January, inflation has been considerably higher thanprojected by CBO, largely because of an unexpectedly sharp rise infood and fuel prices. After accelerating from a rise of 6.8percent in 1977 to a rise of 9 percent in 1978, consumer pricesrose at a 13.4 percent annual rate in the first five months of thisyear. At the same time, economic growth so far this year has beenmuch weaker than expected. Most forecasters currently believe thatthe economy is now or will be shortly in a recession that willeventually include a rise in the unemployment rate to between 7 and8 percent. While it is clear that a serious pause in economicactivity has already occurred, there is a substantial chance thatthe economy will turn out to be either stronger or weaker than theconsensus of forecasts. CBO continues to believe, however, thata mild recession will occur this year, with recovery in 1980.

The CBO Current Policy Forecast

The major elements of the CBO forecast, which assumes thatcurrent budget policies are continued unchanged, can be summarizedas follows:

o Real growth in Gross National Product (GNP) is expected tobe in the -2.0 to 0.0 percent range over the four quartersof 1979, followed by a rebound in 1980 in the 1.9 to 3.9percent range.

xi

o Consumer prices are projected to increase by 9.9 to11.9 percent during 1979, decelerating to 7.9 to 9.9percent during 1980. The deceleration in inflation assumesno additional price shocks and a moderation of priceincreases for both food and fuel.

o The unemployment rate is expected to rise to a 6.4 to7.4 percent range by the last quarter of this year and to a6.7 to 7.7 percent range by the end of 1980.

TABLE 1. SUMMARY OF CBO ECONOMIC PROJECTIONS UNDER CURRENTBUDGET POLICY, CALENDAR YEARS 1979 AND 1980

Economic Variable

GNP (current dollars,percent change)

Real GNP (1972 dollars,percent change)

Consumer Price Index(percent change)

Unemployment Rate, Endof Period (percent)

1977:4to 1978:4(actual)

13.1

4.4

9.0

5.8

1978:4 1979:4to 1979:4 to 1980:4

6.2 to 10.3 9.9 to 14.

-2.0 to 0.0 1.9 to 3.

9.9 to 11.9 7.9 to 9.

6.4 to 7.4 6.7 to 7.

1

9

9

7

Economic forecasts depend critically on assumptions abouteconomic policy and other developments. The current CBO forecastis based upon the following assumptions about fiscal and monetarypolicy:

o Federal spending and tax policies will be those of thefirst budget resolution for fiscal year 1980. Thesepolicies are assumed to result in federal budget outlays of$495 billion in fiscal year 1979 and $540 billion in fiscalyear 1980. The 1980 outlay figure includes an $8 billion

xii

overrun concentrated in transfer payments, national de-fense, and interest. No tax changes are assumed in theforecast other than those included in the first concurrentresolution.

o Monetary policy will remain relatively restrictive throughmost of 1979, even though short-term interest rates areexpected to decline because of weaker demands. However, inline with the Federal Reserve's announced preference formonetary stimulus rather than fiscal stimulus, the FederalReserve growth target for the broadly defined money aggre-gate, M2, is assumed to be raised in 1980.

In addition, the CBO forecast assumes:

o The price of imported oil will increase to $20 per barrelin July of this year, rising thereafter at a rate that is 3percent higher than inflation.

o The exchange value of the dollar will remain near presentlevels.

o The price of consumer foods will increase by about 11percent during the current year, slowing to an 8 percentrise during 1980.

The Recent Slowdown in the Economy

There appears to have been no significant gain in overalleconomic activity so far in 1979. The weakness evident in theeconomy since last December has been concentrated in the house-hold sector; business demands have been relatively strong. Inreal terms, retail sales declined at an 11.1 percent annual ratebetween December and May. While the weakness in sales has beenwidespread, sales of automobiles, particularly the larger models,have declined dramatically since March. Sales of domesticallyproduced autos were off almost 13 percent in the second quarter.

The weakened demand of the household sector is also evident inresidential construction. Housing starts did not bounce back asstrongly as expected from the weather-related decline in theJanuary-February period. Housing starts in the first half of 1979are expected to be almost 20 percent below the second half of1978.

xiii

Data through May show household employment and average hoursworked down in the second quarter of 1979. Nevertheless, pro-duction may have outpaced real sales by a greater amount in thesecond quarter of this year than in the first quarter. Thissuggests that a rise in inventories has taken place and, if finalsales do not snap back, portends some cutbacks in output andemployment in the coming months. The auto industry appears to beparticularly vulnerable because stocks of unsold domestic autoswere at record levels at the end of May.

Recession in 1979

Many of the factors accounting for the recent weakness ofhousehold demands are expected to continue to exert a negativeinfluence on the economy in the projection period:

o The direct effect of the rise in OPEC oil prices sinceDecember, equivalent to more than a $20 billion increase inpersonal income taxes, is expected to reduce disposableincome by 1 percent in 1980.

o Rapid increases in all prices largely due to supply condi-tions will continue to depress real incomes and realwealth, thereby eroding purchasing power.

o Consumer debt will remain burdensome and restrain spending,

o Low consumer confidence will impede spending.

o The spate of consumer buying during the last half of 1978in anticipation of higher prices borrowed heavily fromfuture sales. Consumers are not expected to repeat thatbehavior in the near future despite continuing highinflation.

o Record high mortgage interest rates and rising house pricesare expected to continue to depress housing construction.

o The reduced demand for larger autos, vans, and trucksresulting from rising fuel prices and fuel shortages isexpected to continue for a time.

Business spending is now fairly strong but probably will notremain so. In response to weak retail sales and a rise in businessinventories, producers of consumer goods are expected to reduce

xiv

employment and cut production during the second half of this year.The resulting rise in unused capacity and decline in profitmargins are expected to dampen demand for capital goods later thisyear and in 1980.

Nevertheless, CBO does not expect a major recession thisyear. Except for autos, inventories still appear lean by historicalstandards, so that cutbacks in production to reduce inventories maybe relatively mild. Furthermore, in part because of changingtechnology and government regulation, investment spending isexpected to remain strong in some industries regardless of theslowdown in consumer spending.

Recovery in 1980

Economic developments cannot be forecast as far ahead as 18months with a great deal of confidence. First, economists have notbeen very successful at predicting the timing of turning points inthe economy. Second, the economy in 1980 is likely to be signifi-cantly influenced by some factors that are not yet apparent.Nevertheless, CBO's best guess is that economic growth will recoverin 1980. The projected recovery will be brought about by a numberof factors:

o The ending of a mild inventory adjustment;

o A moderation in supply inflation that permits greater realincome growth;

o A decline in interest rates that boosts housing construc-tion; and

o An improvement in consumer finances and an upturn indurable goods consumption, partly because of replacementneeds and increased residential construction.

Moreover, as indicated earlier, the projected expansion in 1980 isassumed to be accommodated by an easing of monetary policy laterthis year.

Assuming that current budget policies are maintained, the 1980rebound is likely to be weak compared with earlier postwar cyclicalupturns. Rapid price increases are expected to reduce growth

xv

in upturns. Rapid price increases are expected to reduce growth inreal incomes and put upward pressure on interest rates. In addi-tion, assuming that there is no tax cut, the recovery will berestrained by substantial fiscal drag resulting from the combina-tion of inflation, the progressive income tax structure, and weakgrowth in government purchases. Accordingly, the unemployment rateis expected to remain above 7 percent through 1980.

Sources of Uncertainty

The outlook for the economy is always uncertain, but especial-ly at turning points. Most forecasters are now pessimistic aboutthe near-term outlook for both production and employment. But theymay be wrong. First, the timing and size of adjustments in produc-tion and employment depend on whether business firms regard theirinventory stocks as excessive, just right, or too lean. The dataon inventories are not sufficiently reliable to permit forecastersto predict with confidence the timing and size of inventory adjust-ments. Second, a resurgence of consumer spending and continuedstrength in business investment spending cannot be ruled out.Of course, stronger consumer spending that merely representsbuying in advance of expected price increases would not improve thelonger-run outlook.

Both inflation and unemployment could, however, be higherthan forecast by CBO. Possible events that could darken theoutlook over the next 18 months include:

o Further unanticipated supply shocks such as severe fuelshortages that curtail output, a larger than expected risein OPEC prices, or poor farm harvests that boost consumerfood prices above the projected levels;

o A prolonged labor strike in a major sector, such as theauto industry;

o A sharp drop in the international exchange value of thedollar; or

o A more restrictive monetary policy that hinders theprojected recovery in housing construction in 1980.

xvi

Conclusion

Inflation has been worse than expected, and the economyhas weakened since the first of the year. CBO concludes that themost likely outcome for the remainder of 1979 is a mild recessionwith rising unemployment and high, but moderating, rates of in-flation. Economic activity is projected to turn up in 1980. Givencurrent budget policy, however, the recovery is expected to be weakby historical standards, and the unemployment rate is projected toremain above 7 percent throughout 1980.

If the unemployment rate rises significantly, the Congresswill be faced with difficult policy decisions. Economic growthcould be boosted by cutting taxes, but this action would conflictwith the goal of a balanced budget as well as with long-run effortsto reduce inflation. The major impact of fiscal stimulus on theeconomy is usually delayed for more than a year. Assuming that therecession is mild, lasts only a few quarters, and is followed by asizable rebound, budgetary measures to stimulate the economy couldaggravate inflation by providing delayed stimulus when the recoveryis already well underway. If, on the other hand, the recession isdeep or lasts quite long, thereby driving the unemployment rate upto high levels for a prolonged period, tax cuts might serve toameliorate unemployment substantially without significantly aggra-vating inflation.

Unfortunately, fiscal policy must be made in an environment ofuncertainty. We do not know in advance whether unemployment willrise sufficiently to warrant fiscal stimulus. Since the unemploy-ment rate at midyear has not begun to rise and the outlook forinflation and economic growth is very uncertain, perhaps theCongress and the Administration should consider developing acontingency budget plan for future use in case the economicsituation deteriorates significantly.

xvii

^8-096 0 - 7 9 - 3

CHAPTER I. CURRENT ECONOMIC DEVELOPMENTS

On balance, the events unfolding since the end of 1978 havesupported the basic message of the January forecast of the Con-gressional Budget Office (CBO): that a recession is likely to occurin 1979, followed by a mild recovery in 1980. JL/ The economy hasslowed down significantly so far this year, although sooner thanCBO had anticipated. Also in the January report, CBO was lessoptimistic than the Administration that the wage-price programwould be able to restrain inflation. And the rate of price in-crease has accelerated sharply, well above the rate foreseen by CBOsix months ago. This report reviews recent economic developmentsand updates the forecast.

PRICES AND WAGES

After accelerating from a 6.8 percent increase in 1977 to 9.0percent in 1978, the Consumer Price Index (CPI) rose at a 13.4percent annual rate in the first five months of this year (seeFigure 1). The acceleration has contributed to the decline in realwage-and-salary incomes, the weakening of the housing market, andthe slump in consumer confidence.

Several factors have caused the recent acceleration, butthree are most significant. 2^/

_!/ Congressional Budget Office, The Fiscal Policy Response toInflation: A Report to the Senate and House Committees on theBudget. Part I (January 1979), referred to hereafter as"January report."

27 The contribution of each item to the acceleration in the CPI iscalculated by assuming that the price of the item continued torise at the same rate it did in 1978; the assumed all-itemsCPI change is then subtracted from the actual CPI change.Given the problems of compounding and inconsistent seasonaladjustments, however, the results are only rough estimates.

Figure 1.Percent Changes in the Consumer Price Index and Selected Components

Percent, Annual Rate10 15 20

XXXXXXXXXXXXKXXXXXXXXXXXXXXXXXXW

|!J CPI for Home FinancingCPI for EnergyCPI for FoodTotal CPI: All Urban Workers

1979:2

1979:1

1978:4

1978:3

1978:2

1978:1

1977:4

1977:3

1977:2

1977:1

1976:4

1976:3

1976:2

1976:1

-10 -5 0 5 10 15 20Percent, Annual Rate

SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.

NOTE: Point for 1979:2 is average of April and May values.

o Food prices rose sharply, contributing about 1/2 per-centage point to the overall CPI acceleration;

o A jump in energy prices added roughly 2-1/2 percentagepoints to the December-May inflation rate; and

o Rising mortgage interest costs contributed about another 1percentage point to the increase in consumer price in-flation.

Food Prices. The CPI for food so far this year has risen ata 14.7 percent annual rate, as compared with 11.8 percent in 1978(see Figure 1) . Much of the acceleration has resulted fromrapidly rising beef prices. After drawing down stocks for anunusually long period of five years, ranchers have been attemptingto rebuild their herds by withholding heifers from market and,consequently, reducing available supplies of beef (see Table 1) .Recently, beef prices have stabilized as consumer resistance tohigh costs was encountered and as pork and poultry supplies in-creased. But a new upward pressure on food prices has developedrecently in grains. In part as a result of rising export demand,grain prices have risen sharply over the past three months.

TABLE 1. CATTLE INVENTORIES, 1970-1979: MILLIONS OF HEAD ON JANUARY 1

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979

Stock 112.4 114.6 117.9 121.5 127.8 132.0 128.0 122.8 116.3 110.9

SOURCE: U.S. Department of Agriculture.

Even if prices received by farmers remain stable for therest of this year, retail food prices likely will continue torise. Marketing costs, largely for transportation, packaging,

and wages, account for roughly two-thirds of the consumer's retailfood bill, and these costs are expected to increase significantlyfurther in 1979.

Energy Prices. The OPEC price for crude oil was raised toabout $20 a barrel at the cartel's June meeting (see Table 2).This is an increase of nearly 60 percent since last December. Butthe rise occurred less abruptly than the changes in the officialbenchmark price suggest. Before the OPEC meeting, the effectiveprice with surcharges was already in the neighborhood of $17, upmore than 30 percent from the end of last year. The sharp increasein petroleum prices early this year originated in the drop inIranian production of crude oil.

TABLE 2. OPEC PRICE OF OIL AND U.S. IMPORTS, 1972-1979

June July1972 1973 1974 1975 1976 1977 1978 1979:1 _a/ 1979

OPEC Priceof Oilper Barrel(dollars) b/ 2.13 2.40 10.95 10.46 10.46 12.09 12.70 14.70 20.00.C/

U.S. Importsof Crude Oiland RefinedProducts (mil-lions of bar-rels per day) d/ 4.47 5.88 6.36 5.41 7.48 8.94 7.85 8.36 N.A.

Imports as aPercentof U.S. Con-sumption 28.6 35.7 39.5 34.6 44.4 49.5 43.0 41.0 N.A.

aj First-quarter average.

b/ Official OPEC marker sales price of Saudi Arabian light oil, except for 1979which is the average OPEC price.

_c/ Estimate of the new average OPEC price.

d_/ Excludes imports for Strategic Petroleum Reserves.

SOURCES: U.S. Department of Energy, Energy Information Administration; CentralIntelligence Agency, National Foreign Assessment Center.

The OPEC price increase and the accompanying petroleum supplyshortages have resulted in the largest jump in domestic fuel pricessince the quadrupling of OPEC prLces in 1974. Prices for gasolineand fuel oil have risen at an annual rate of over 50 percent duringthe first five months of the year. This increase in retail pricesis significantly higher than wculd have resulted solely from apassthrough of the higher OPEC prices. Nevertheless, the OPECincrease since December is large. The drain of purchasing power toforeign oil producers as a result of the 1979 price increases couldtotal more than $20 billion (at an annual rate) , amounting toroughly 1-1/4 percent of disposable personal income in the thirdquarter of 1979. The 1974 quadrupling of OPEC prices also drainedclose to $20 billion in the firs^ year, approximately 2 percent ofdisposable income.

Even though energy prices are not expected to continue toincrease at recent rates, prospects for the future are not favor-able. The Administration's policy of decontrol of domestic oilprices, along with the likelihood of a continuing tight supplysituation at least in the near term, should keep energy pricesrising at a pace greater than thd average rate of inflation for theeconomy as a whole.

Home Financing, Taxes, an i Insurance. The cost of homefinancing, taxes, and insurance (FTI), as measured in the CPI,increased at an annual rate of fnore than 25 percent in the firstfive months of the year. Most of^ the upward pressure has come fromrapidly rising mortgage intereslj: costs, which account for nearlythree-quarters of this CPI category. Rapid changes in the FTIcategory can have a significant] impact on the overall CPI. Infact, many analysts believe tbjat the FTI category is given anunrealistically large weight in the overall measure so that therecent increase in living costs lias been overstated.

Labor and Materials Costs. Although food and energy pricesare responsible for much of thfe increase in consumer price in-flation, the prices of other donsumer goods and services haveaccelerated as well. So far tjhis year, the CPI less food andenergy has risen at an annual ^rate of 10.2 percent, as comparedwith a rate of 8.5 percent in 1978. As noted earlier, most ofthis acceleration can be attributed to mortgage interest costs.However, large jumps in the rat^s of increase of unit labor costsand materials prices must sh4re at least some of the blame.

Unit labor costs rose at an annual rate of 15 percent in thefirst quarter of this year. This is significantly larger than thetotal 1978 increase of 9.0 percent, even after removing the effectsof January's minimum wage and Social Security tax increases. Theacceleration, however, was due largely to a sharp drop in pro-ductivity of more than 4 percent at an annual rate, as comparedwith a rise of 0.7 percent in 1978. Firms often view such move-ments in productivity as transitory and, therefore, these changesare not fully reflected in prices. Thus, the acceleration in unitlabor costs probably has had a relatively small impact on the CPIacceleration so far this year. This does not mean, however, thatlabor costs are not relevant to the inflation problem. On thecontrary, high unit labor costs are the major reason why thefundamental rate of inflation—eliminating the transitory ele-ments—is currently in the neighborhood of 8 percent, an ex-ceptionally high core rate.

Prices of raw materials accelerated sharply for most of theperiod since last fall, although these prices have softened a bitrecently. After rising at an annual rate of 27 percent fromSeptember to March, wholesale prices for crude nonfood materialsexcept fuel declined in April and rose only moderately in May.Since materials prices tend to lead business trends, such a slowingis consistent with CBO's projection of an economic downturnthis year.

Raw materials prices may have contributed somewhat to therecent acceleration in consumer prices. Overall, however, thisimpact was relatively small because of the small weight of rawmaterials in the value of finished products.

Wages. While prices have accelerated sharply this year, therehas been little acceleration in wages from the 1978 rate of in-crease. In the first quarter of this year, the average hourlyearnings index increased by about 9.4 percent at an annual rate,as compared with a rate of 8.3 percent over 1978. This rise doesnot indicate an acceleration in wages; rather, it results from theconcentration of the effect of the 1979 minimum wage increase inthe first quarter. Last year's first-quarter increase, reflectinga somewhat greater adjustment in the minimum wage, was substan-tially larger than the gains in the other quarters. In the same waywage measures other than average hourly earnings, such as compensa-tion per hour and the employment cost index, have also shown littleacceleration so far this year, as is shown in Table 3.

TABLE 3. SELECTED WAGE MEASURES, 1978-1979: PERCENT CHANGE

Wage Measure 1978:1 a./ 1978 _b/ 1979:1 _§/

Compensation per Hour,Private Business Sector 12.2

Average HourlyEarnings Index 9.2

Employment Cost Index 7.8 _c/

Collective BargainingFirst-Year Settle-ment, Wage Rates _§_/ 9.3

9.8 11.1

8.3 9.4

7.7 Al 8.2 d

7.8 9.3

_a/ Percent change from previous quarter, annual rate, seasonallyadjusted.

b/ Percent change from four quarters earlier.

cf Three-month percent change ending in March, annual rate, notseasonally adjusted.

_d/ Twelve-month percent change ending in December.

ej Those who received increases; excludes those whose settlementsinvolved no increase in the first year. Not seasonally ad-justed.

SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.

The indicators of future wage behavior are mixed. Factorsthat would work to hold down the growth in labor costs are theexpected higher rate of unemployment later this year and in 1980,the smaller scheduled increases in the minimum wage and in payrolltaxes next year, and the success of the Administration's wage-priceprogram. Other influences, however, could cause wage gains toaccelerate. Most important among them is the recent rapid increasein the inflation rate, which may put a strong upward pressureon levels of pay.

48-096 0 - 7 9 - 4

On balance, there is not much likelihood of a significantdeceleration of wage gains this year or in 1980. Indeed, if therecent rapid supply-side inflation feeds more fully into laborcompensation than CBO now anticipates, wage growth could acceleratesubstantially in the next year and a half, despite the expectedslackening in labor demand.

FINAL SALES

The growth in economic activity has weakened sharply since theend of last year, par t ly because of the rapid acceleration ofinflation. Measured in constant dollars, total final salesincreased only slightly in the first quarter, up at an annual rateof 0.1 percent after rising 4.4 percent during 1978 (see Table 4) .

TABLE 4. CHANGES IN CONSTANT DOLLAR FINAL SALES AND ITS MAJORCOMPONENTS, 1976-1979: PERCENT CHANGE, AT ANNUAL RATES

1976:4 to1977:4

1977:4 to1978:4

1978:4 to1979:1

Total Final Sales

Personal ConsumptionExpenditures

Fixed InvestmentResidentialNonres idential

Government PurchasesFederalState and Local

4.9

4.8

11.115.39.1

5.16.34.3

4.4

4.0

6.40.09.4

1.8-1.1 a_/3.5

0.1

0.7

-1.0-14.45.1

-4.2-1.9 aj-5.5

Exports

Imports

-1.3

10.3

16.4

9.3

13.1

5.2

aj The decline in federal purchases results from Commodity CreditCorporation transactions.

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

8

Furthermore, the available data suggest a decline in final salesin the April-June period. The preliminary estimate of second-quarter Gross National Product (GNP) will not be released untilJuly 20; on the basis of data currently available, however, CBOcalculates that there was little—if any—real growth in theeconomy during the first half of 1979.

HOUSEHOLD SECTOR

The slowdown in total spending so far this year has beenconcentrated in the household sector, in both personal consumptionand home purchases. The weakness in household demands appears tobe caused by four factors:

o Total personal income, after adjustment for inflation,declined during the first five months of the year (seeFigure 2). As noted above, this reduction apparently didnot result from a slowdown in the growth of labor com-pensation. Rather, the decrease in real income resultedlargely from higher supply-side inflation. In addition,nominal income growth slowed because of the sharp de-celeration in employment growth. Total household employ-ment has risen at only a 1.2 percent annual rate since theend of last year, as compared with a 3.6 percent gain for1978 as a whole.

o The ratio of household debt to total disposable incomereached a record high last winter, as did the ratio ofrepayments to income (see Figure 2). The rapid expansionof credit in 1978 makes it unlikely that further debtexpansion will provide impetus to consumer spending thisyear.

o Interest rates have risen rapidly since last fall, ap-parently dampening home sales.

o Finally, consumer confidence continues to slump (seeFigure 2). Consumer pessimism about the future appearsrooted in the chronically high inflation and, more re-cently, in uncertainty about energy supplies. In addition,survey data on current purchase plans suggest that thewidespread strategy to buy in advance to beat inflation isgiving way to attempts to build precautionary savings.Buying plans for automobiles and houses have declinedrecently.

Figure 2.Household Sector Conditions

Real Personal Income900

I

75

70

65

60

25

Household Debt andDebt Repayments as a Percentof Disposable Personal Income

Installment and Mortgage Credit

Outstanding Relative to Income

Installment Credit and Mortgage

Repayments Relative to Income

1 2 3 4 1 2 3 4 1 2 3 4 1 2

1976 1977 1978 1979

SOURCES: U.S. Department of Commerce, Bureau ofEconomic Analysis; U.S. Department ofLabor, Bureau of Labor Statistics.

1 2 3 4 1 2 3 4 1 2 3 4 1 2

1976 1977 1978 1979

SOURCES: Board of Governors of the Federal ReserveSystem; U.S. Department of Commerce,Bureau of Economic Analysis.

Index of Consumer SentimentIndex: 1966 = 100.

90

80

70

1 2 3 4 1

SOURCE: University of Michigan, Survey Research Center.

10

Automobile Sales. Sales of domestically produced automobileshave slumped badly since the end of last year—down nearly 12percent in the second quarter of 1979 from the final quarterof 1978 (see Figure 3) . This is the most rapid decline since the1973-1975 downturn. As a result, auto inventories reached recordhigh levels in May and apparently continued to rise in June.

The sales weakness and the consequent inventory builduphave been concentrated among larger autos. In addition, sinceimported autos are weighted toward smaller models, the import shareof the market reached a record high level of 24 percent in May.

In part, the weakness in auto sales has been caused by thesame factors that have weakened overall retail sales. The declinein constant dollar personal income reduces the ability of anumber of households to take on monthly auto payments. Specifi-cally, rapid price inflation for necessities such as food andenergy and the slowdown in employment growth have restraineddiscretionary income growth and provided an incentive to postponereplacing existing autos.

In part, however, the sales deterioration results from theauto industry's particular vulnerability to public uncertainty overenergy. The sharp drop in sales of larger models coincided roughlywith two other events: long lines at gasoline stations in partsof the country and the rapid increase in gasoline prices (see Table5). As depressing as the energy situation has been on domesticauto sales, it apparently has had an even greater adverse effect onpurchases of recreational vehicles and small trucks.

TABLE 5. INCREASES IN CONSUMER PRICES FOR GASOLINE, DECEMBER1978-MAY 1979: PERCENT CHANGE, MONTHLY RATE

1978: 1979

December January February March April May

1.7 2.0 2.0 3.8 6.0 5.0

SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.

11

Figure 3.

Sales of Domestic Automobiles

11.01972:1 to 1975:2

1976:1 to 1979:210.0

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

NOTE: Point for 1979:2 is average of April and May values.

12

Consumer Spending, Other Than for Autos. Purchases of otherconsumer goods—though not as weak as auto sales—have also de-teriorated, once adjusted for inflation (see Table 6). The datasuggest that households have cut back on a wide variety of consumergoods since the end of last year. Large nominal spending gainswere recorded by grocery stores and gasoline service stations,but the increases wholly reflect sharply higher prices. Morediscretionary purchases—general merchandise, furniture, food awayfrom home—also failed to rise as rapidly as prices.

TABLE 6. CHANGES IN RETAIL SALES AND CONSUMER PRICES, SELECTEDMARKET CATEGORIES: PERCENT CHANGE FROM DECEMBER 1978 TOMAY 1979

Retail Sales Consumer Prices

Total, Excluding Autos 1.5 N.A.

Food at HomeGasolineGeneral MerchandiseApparelFurnitureEating and Drinking PlacesMail— Order Houses

4.410.51.20.23.0 a/1.4

-30.0 a/

6.120.1N.A.2.12.3 a/6.0

N.A.

N.A. = Not available.

aj Change is from December to April.

SOURCE: U.S. Department of Commerce, Bureau of the Census; U.S.Department of Labor, Bureau of Labor Statistics.

Housing. The final component of household spending, homepurchases, has also been weak so far this year. An average of1.68 million (annual rate) housing units were begun in the firstfive months of the year, down sharply from the 2.1 million rate

13

late in 1978 (see Figure 4) . The sharp drop in the first quarterresulted in part from adverse weather conditions, but the failureof starts to rebound fully in the spring—as well as the 19 percentdecline in sales of new single-family homes—suggests that thewidely expected slackening of housing activity is underway.

The indications are that housing will weaken further in thecoming months. Consumer sentiment surveys reveal that plans to buya house (the Conference Board Survey) and evaluations of whether itis a good time to buy a house (the University of Michigan Survey)have deteriorated from a year ago (see Table 7) . This deterio-ration does not result from a fundamental lack of demand. It hasbeen estimated that normal household formation would require atleast 2 million new. housing units a year, and home purchase con-tinues to be a good hedge against inflation. Rather, the slowdownresults both from household inability to make higher monthlymortgage payments and, perhaps to a lesser extent, from a shortageof available mortgage funds.

TABLE 7. HOUSE-BUYING ATTITUDES, 1978-1979: PERCENT OF RESPONDENTS

Plan to BuyHouse in NextSix Months a/

Now Is GoodTime to

Buy House _b/

1978:1234

1979:12

4.64.03.53.9

3.53.3

55565045

4951

a_l The Conference Board Survey.

W University of Michigan Consumer Survey.

14

Figure 4.Housing Sector

Millions of Units, Seasonally Adjusted Annual Rate2.5

Housing Units Started(New Privately Owned Units)

NOTE: Point for 1979:2 is averageof Aptil and May values.

2.0

1.5

1.0

0.5

./

*

1 1 1

Total Uni

/^

Single-Family

^

Multifamily Hou;

1 1 1

s Started

V \

Houses Started

N/̂ "N

ing Units Started

...X*"" v

1 1 1

,

^

\/

'•+*.-**-

1

Millions of Units, Seasonally Adjusted Annual Rate

New Single-Family Houses Sold

NOTE: Point for 1979:2 is April value.

SOURCES: U.S. Department of 0.6Commerce, Bureau ofthe Census; U.S. Depart-ment of Housing andUrban Development.

I.U

d

0.9

O O

0.7

O R

'

> v /

1 1 1 1 1 1

./^\

1 1 1

-

V

1 "1 2 3 4 1 2 3 4 1 2 3 4 1 2

1976 1977 1978 1979

15

Between December and May, home purchase prices increased atan 11 percent annual rate, while financing costs were up at a 25percent rate. As shown in Table 8, using a qualification ruleoften used by lenders, the annual income needed to qualify for amortgage on a median-priced house has been rising rapidly, up morethan 40 percent in just two years. The University of Michigansurvey found that 52 percent of the respondents cited high homeprices and high mortgage rates as reasons for thinking that now isnot a good time to buy a house, up from 49 percent in the fourthquarter of 1978.

TABLE 8. ANNUAL INCOME LEVEL NEEDED TO QUALIFY FOR MORTGAGE,1977-1979: BY HALF YEARS

1977:1 1977:11 1978:1 1978:11 1979:1 a/

QualifyingIncome Level $14,700 $15,600 $17,200 $19,100 $21,200

NOTE: Figures are based on a 20 percent down payment, the medianhouse price, and the effective interest rate for a 30-yearmortgage on a new one-family home, using the rule that themonthly payment (principal and interest) should not exceed25 percent of gross monthly income.

aj Estimate.

SOURCES: Federal Home Loan Bank Board; U.S. Department of Com-merce, Bureau of the Census; U.S. Department of Housingand Urban Development.

Conditions influencing the supply of mortgage funds alsosuggest contraction. Until recently, funds were generally availableexcept in some areas with usury ceilings on the maximum mortgageinterest rate that can be charged. Since mid-March, however,savings and loan associations—the main source of mortgage funds—have apparently experienced some difficulty in attracting funds.In April, thrift institutions had net withdrawals of deposits,

16

although the data show some rebound in May (see Figure 5) . Inmid-March, federal regulations were changed to reduce the maximuminterest rate that thrifts can pay on $10,000 six-month certifi-cates by 1/4 percentage point and to prohibit compounding ofinterest. J3/ Given the erratic recent behavior of deposits atthrifts, more data are needed to determine to what degree thischange will result in a squeeze on mortgage funds available laterin the year. In addition, borrowing from the Federal Home LoanBank Board—which was relied on heavily by thrifts during thesecond half of 1978 as a source of loanable funds—appears unlikelyto provide a similar increase in loanable funds this year.

Figure 5.Net Savings Inflow at Insured Savings and Loan Associations

4000

§ 2000 -

-2000

SOURCE: Federal Home Loan Bank Board.NOTE: Last point plotted is May. Data are seasonally adjusted by the Congressional Budget Office.

Largely because of these various problems, mortgage loancommitments held and mortgage loans closed are down so far in 1979,after showing substantial strength toward the end of last year (seeTable 9) .

37 The 1/4 percentage point reduction holds when theTreasury bill rate is 9 percent or higher.

26-week

17

TABLE 9. MORTGAGE LOAN COMMITMENTS AND CLOSINGS AT SAVINGS ANDLOAN ASSOCIATIONS, 1978-1979: IN MILLIONS OF DOLLARS,QUARTERLY RATES

1978:1 1978:2 1978:3 1978:4 1979:1 1979:2 _a/

Commitments 66,513 63,255 63,789 66,699 61,927 62,444

Closings 29,352 26,505 25,929 29,157 25,390 25,835

NOTE: Data are seasonally adjusted by CBO.

ji/ Estimated from April and May data.

SOURCE: Federal Home Loan Bank Board.

BUSINESS SECTOR

In contrast to the household sector, the business sectorcontributed to real growth in the f i rs t quarter of this year.Indeed, without the increased outlays for plant and equipment andfor higher inventories, total economic activity in the f i rs tquarter would have been below that in the final quarter of 1978.

Business Fixed Investment. The need for additional capacityto meet rising demand spurred business spending for plant andequipment last year, and the momentum carried over into theearly months of 1979 (see Table 10) . Spending for durable equip-ment rose at a 9.9 percent annual rate in the first quarter, ascompared with the 7.3 percent gain during all of 1978. Althoughoutlays for the other component of business fixed investment—structures—declined early this year, unusually harsh winterweather hindered the construction industry in general; and businessconstruction rebounded in March and April as the weather improved.Spending for industrial building in the three months ending inApril was 10 percent above that in the preceding three-monthperiod.

Indicators of near-term business f ixed investment havebecome mixed recently. On the plus side, a number of indicatorsremain at relatively high levels, including the backlog of orders,

18

TABLE 10. BUSINESS FIXED INVESTMENT, 1975-1979: PERCENT CHANGE INCONSTANT DOLLAR VALUES

1975:4 to 1976:4 to 1977:4 to 1978:4 to1976:4 1977:4 1978:4 1979:1 a/

Nonresidential FixedInvestment, Total 8.6 9.1 9.4 4.9

Structures 3.0 7.0 13.9 -4.9

Producers' DurableEquipment, Total 11.4 10.1 7.3 9.9

Autos, Trucksand Buses 21.5 27.0 12.2 6.8

Other Machin-ery andEquipment 8.3 4.2 7.3 11.1

aj Compound annual rate of change.

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

new bookings for nondefense capital goods, nonresidential construc-tion contracts, and manufacturers' capital appropriations (seeFigure 6) . And the Commerce Department's spring survey of antici-pated plant and equipment expenditures, taken in April and May,found a planned spending increase for 1979 of 12.7 percent, 1.4percentage points above the planned increase reported three monthsearlier. Once adjusted for inflation, such spending would implyabout a 4 1/2 percent increase in survey-based business investmentthis year—somewhat below the gain in 1978.

On the negative side, some indicators have been showingweakness lately. Most notably, as shown in Figure 6, new orders fornondefense capital goods dropped sharply in April and by May were12 percent below the advanced March level. This series tends tolead actual capital spending by three to six months. In addition,manufacturing capacity utilization has been edging down this

19

Figure 6.Indicators of Business Spending

Unfilled Orders forNondefense Capital Goods

New Orders forNondefense Capital Goods

IJU

i3 110

1 100CO

eI 90a

1 80

£

70

1

-

1 1 1

/

^I I I

y

/ -

-

I "1 2 3 4 1 2 3 4 1 2

1977 1978 1979

iO

cc> 24

JZc

1 22a>

1 20

1 18a>

"- 16

o 14O

I 12

£ ^

-

-

-^f

1 1 1

^

I I I

A~' V

-

I 11 2 3 4 1 2 3 4 1 2

1977 1978 1979

SOURCE: U.S. Department of Commerce,Bureau of the Census.

NOTE: Last point plotted is May.

Nonresidential Construction Contracts

SOURCE: U.S. Department of Commerce,Bureau of the Census.

NOTE: Last point plotted is May.

Newly Approved Capital Appropriations,Manufacturing Firms

1o1M

f

21

20

19

18

17

16

15

14I I I

1 2 3 4 1 2 3 4 1 2

1977 1978 1979

SOURCE: McGraw-Hill Information Systems Company.

NOTE: Last point plotted is April.

2 31977

2 31978

1 21979

SOURCE: The Conference Board.

20

year and will continue to decline if household spending remainsweak (see Table 11) . Excess capacity removes a significant impetusto business fixed investment.

TABLE 11. MANUFACTURING CAPACITY UTILIZATION, 1978-1979: PERCENT,SEASONALLY ADJUSTED

1978:1 1978:2 1978:3 1978:4 1979:1 1979:2 a/

Total Manufac-turing 82.1 84.0 85.0 85.9 86.1 85.2Primary pro-cessing 83.8 86.3 87.8 89.0 88.2 87.4

Advanced pro-cessing 81.1 82.7 83.5 84.1 84.9 83.9

a./ Data for April and May only.

SOURCE: Board of Governors of the Federal Reserve System.

Inventory Investment. Business inventories typically begin torise relative to sales around a peak in the business cycle.This is because producers usually maintain production levels for aperiod following a decline in demand, which leads to an unintendedinventory accumulation.

The ratio of inventories to final sales increased early thisyear as business stocks began to build at a quickened pace (seeFigure 7). By historical standards, the overall inventory-to-sales ratio has remained low. But this ratio has been trendingdown for some time now, and the recent buildup may signal someunintended accumulation because of weak final sales. Such un-planned increases are important because they eventually lead tocutbacks in production and employment.

To be sure, the inventory increase so far this year was notwholly unplanned. High levels of capacity utilization, rapidinflation, slower deliveries of ordered goods, and the greaterrisk of strikes interrupting normal delivery patterns have led

21

Figure 7.Business Sales and Inventories

Busine290

270

250

230

"

Perce6.5

6.0

5.5

5.0

4.5

4.0

"s

Business Sales and Change in Business Inventories Chs Sales (Billions of Dollars, Seasonally Adjusted Monthly Rate) Business Inve

i i i

\__

i i i/i 1 1

Busin(Let

S^

Y'?7'

ess Sales ,t Scale)/

s/

1 1 I

, —f

Change inkx

I I I

SBusiness 1Right Scale

•"'Nv

1 1 1

^-

'

wentories

i i i

y

' **'

^

1 2 3 4 1 2 3 4 1 21977 1978 1979

Business Inventories as a Percent of Business Salesnt Pe

A\ A

FV^

i i i

\V

1 1 1

\

\i

IV

/x/

1 1 1

\ t

V\V

1 1 1 i 1 i

\ .V

,T:

1 2 3 4 1 2 3 4 1 21977 1978 1979

ange inntories

20.0

15.0

10.0

5.0

0

rcent6.5

6.0

5.5

5.0

4.5

4.0

^

Source: U.S. Department of Commerce, Bureau of the Census.

Note: Last point plotted is April.

22

many firms to desire increased stocks. But the slowdown in house-hold spending this year has been greater than generally antici-pated and has left producers in some markets, especially automo-biles, with higher inventories than desired. As described earlier,weak auto sales have resulted in record high stocks of unsold carsin May and little likelihood of any improvement in June.

Despite autos and a few other product areas, however, theinventory picture in the first four months of 1979 remains gener-ally consistent with cautious business behavior which attempts toavoid serious imbalances between stocks and sales. Although lowinventory-to-sales ratios are no guarantee against near-term futureunintended accumulations, there is little evidence of the type ofoverordering for inventory building that occurred in 1973-1974 andcontributed to the severity of the last recession.

INTERNATIONAL SECTOR

Growth of exports relative to imports strengthened over thelast two quarters and may continue as a source of strength in thecoming months (see Figure 8) . The U.S. balance of manufacturedgoods showed gradual but continued improvement over the past year,partly because of the depreciation of the dollar. After fallingsharply toward the end of 1978, the exchange value of the dollarrose during the first months of 1979. Its value, however, remainedbelow its 1978 high and should still help export growth relativeto import growth through the next year.

These trends toward a larger net export balance and theeconomic stimulus it would provide could be overwhelmed by theimpact of higher prices of petroleum imports. Domestic petroleumproduction is not expected to increase significantly in the nearfuture; thus, reliance on imported petroleum products will con-tinue. Current gasoline shortages in some areas and fears aboutshortages of heating oil next winter have led the Administration toencourage purchases of crude oil and petroleum products in the spotmarket in spite of record high prices.

STATE AND LOCAL GOVERNMENT SECTOR

An important measure of the impact of state and local govern-ments on the overall U.S. economy is the size of their combinedsurplus or deficit. The budget, balance of state and local govern-ments (National Income Accounts basis) declined by $1.3 billion

23

Figure 8.International Sector

250Imports and Exports of Goods and Services, NIA Basis

acc

1225

€ 200IJs£= 175

Imports

Exports

150

f I I I I I f2 3

1978

90

1 2 3 4 1

1977

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

Trade-Weighted Exchange Value of the Dollar

85

80

Index: May 1970= 100.

1

1979

f f1 2 3 4

1977

SOURCE: Morgan Guaranty Trust Company.

2 31978

11979

24

in the first quarter of 1979, despite a growth of only 1.4 percent,at an annual rate, in weather-depressed total outlays by thissector (see Table 12). The decline in this balance reflected botha fall in nominal personal tax revenues and a reduced level offederal grants. Excluding social insurance trust fund accounts,state and local government surpluses, fell by $2.1 billion to alevel of $3.8 billion. The decline continued a general movementtoward reduction that began in the second quarter of 1978. Thisdrop reflected measures to reduce property tax burdens—mostnotably Proposition 13 in California.

TABLE 12. STATE AND LOCAL GOVERNMENT RECEIPTS AND EXPENDITURES, 1977-1979: IN BILLIONS OFDOLLARS, NIA BASIS, SEASONALLY ADJUSTED ANNUAL RATES

Total Surplus

Social InsuranceTrust Fund Surplus

Remaining BudgetSurplus

Total Spending(Percent change)

Purchases(Percent Change)

Total Receipts(Percent Change)

Receipts ExcludingGrants

(Percent Change)

Grants(Percent Change)

CalendarYear1977

29.6

18.0

11.5

266.7( 8.3)

248.9( 8.4)

296.2(11-0)

228.8(11.4)

67.4(10.2)

CalendarYear1978

28.4

21.2

7.2

299.8(12.5)

280.2(12.6)

328.1(10.8)

251.2( 9 . 8 )

76.9(14.1)

1978:1 aj

30.7

20.2

10.5

291.0(11.4)

271.4(11.9)

321.6(11.3)

246.7(11.2)

74.9(11.3)

1978:11 a./

26.1

22.3

3.9

308.6(12.5)

288.9(13.3)

334.7( 8.3)

255.8( 7.5)

78.9(11.0)

1978:4 bf

28.8

22.9

5.9

311.3( 7 .4)

292.0( 9.0)

340.1(13.9)

259.8(13.5)

80.3(15.3)

1979:1 I/

27.5

23.7

3.8

312.4( 1.4)

294.0( 2 . 7 )

339.9(-0.2)

262.9( 4 .9)

77.0(-15.5)

a./ Half year.

b/ Quarter.

SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis.

25

Federal grants, a major source of funds to state and localgovernments, declined by 15.5 percent in the first quarter of thisyear, roughly offsetting the 15.3 percent increase in grantsin the fourth quarter of 1978 that included a one-time $2.2 billionretroactive payment of social service grants. During 1978, federalgrants to state and local governments rose by 14.1 percent, largelyreflecting substantial increases in outlays for public serviceemployment and public works programs. Under current policy assump-tions that include cuts in public service employment grants, acessation of countercyclical revenue sharing, and a spend-out ofremaining budget authority for public works programs, CBO estimatesthat federal grants will grow by only 1 percent in 1979, followedby a rise of 4.7 percent in 1980. The slower growth in grantscoupled with measures to reduce state and local tax burdens likelywill dampen the growth in state and local spending.

EMPLOYMENT AND UNEMPLOYMENT

Labor market data at midyear show significantly less strengththan they did at the end of 1978 (see Figure 9) . Total householdemployment increased at only a 1.2 percent annual rate during thefirst five months of the year, down sharply from last year's paceof 4.3 percent and below the growth rate of the population aged 16and over. In May, only 48 percent of 172 industries reported jobgains, as compared with 76 percent last December; except for April,which was depressed by the Teamsters' strike, this was the lowestmonthly level in nearly three years. Furthermore, average weeklyhours—perhaps the best lead indicator of labor market develop-ments—have fallen so far this year. The average workweek ofproduction or nonsupervisory workers in the private sector droppedto 35.6 hours in May—0.3 hour below December and, excluding thestrike-depressed April figure, the lowest level in more than ayear. The factory workweek also has been falling and was down to40.2 hours in May—0.5 hour below December.

The principal exception to the trend toward weakening has beenthe unemployment rate. As shown in Figure 9, the jobless rate inMay was estimated at 5.8 percent—the tenth consecutive month inwhich unemployment has hovered between 5.7 and 5.9 percent. Sincelayoffs tend to lag a downturn in final sales, it is not surpris-ing that the jobless rate had not increased by May.

It would be surprising if the unemployment rate did not risein the coming months. Production growth is expected to be weak,

26

Figure 9.Labor Market Conditions

Percent Change in Employmentfrom Three Months Earlier

1 2 3 4

1977

1 2 3 4 1 21978 1979

Unemployment Rate

Average Weekly Hours Worked41

40

39 -

38

37 -

36

35 -

/1

-

'AIIF

I I I

/vx~^ Manufacturing

Workers

/*~~*-~*

rivate Nonfarm Wor

I I I

•~1i

i ;

V-

-

-Akers

I 11 2 3 4 1 2 3 4 1 2

1977 1978 1979

Employment Diffusion Index: Percentof Industries in Which EmploymentIncreased Over a One-Month Span

SOURCE: U.S. Department of Labor, Bureau of Labor Statistics.NOTE: Last point plotted is May.

27

Figure 10.Construction and Automobile Industries

Construction Industry, 1973:1 to 1975:2 Automobile Industry, 1973:1 to 1975:2Millions of Houses Millions of Workers Millions of Autos Millions of Workers0.75 FT 1 1 14.4 11.01 1 1 11.1

0.68 - Construction\ Employment

\ (right scale)

Motor Vehicles andEquipment Employment• (right scale)V ^^-——

— Auto Sales(left scale)Houses Sold

(left scale)

0.47

0.40 h

1 2 3 4 1 2 3 4 1 2

1973 1974 1975

Construction Industry, 1976:1 to 1979:2Millions of Houses Millions of Workers

Construction/ Employment

J (right scale)

-| 0.6

1 2 3 4 1 2 3 4 1 2

1973 1974 1975

Automobile Industry, 1976:1 to 1979:2Millions of Autos Millions of Workers11.01 1 1 1 11.1

0.55

10.0

9.0

3.5 8.0

Motor Vehicles and

.Equipment Employment,

(right scale) /s1.0

0.9

0.8

1 2 3 4 1 2 3 4 1 2 3 4 1 2

1976 1977 1978 1979

NOTE: Point for 1979:2 is average of April and May

SOURCES: U.S. Department of Commerce, Bureau ofthe Census; U.S. Department of Labor,Bureau of Labor Statistics.

1 2 3 4 1 2 3 4 1 2 3 4 1 2

1976 1977 1978 1979

NOTE: Point for 1979:2 is average of April and Mayvalues for sales and is April value for employment.

SOURCES: U.S. Department of Commerce, Bureau ofEconomic Analysis; U.S. Department ofLabor, Bureau of Labor Statistics.

28

restraining employment, while the normal rise in the labor forceis likely to be augmented by persons seeking to add to inflation-eroded family incomes. In addition, a number of sectors appearpoised for a reduction of employment. Figure 10 shows the employ-ment-sales situation in two critical industries, automobiles andconstruction, and suggests that substantial layoffs could occur ineach industry if final demands for their products remain weak. Andthe impact of such cutbacks would be widely felt. It is estimatedthat one job in either industry is associated with 1 1/2 to 1 3/4jobs in directly related industries.

29

CHAPTER II. POLICY DEVELOPMENTS AND THE ECONOMIC OUTLOOK

The performance of both prices and output since January hasbeen considerably worse than CBO forecast last January. Consumerprices, after rising at 6.8 percent in 1977 and 9.0 percent in1978, accelerated to a 13.4 percent annual rate during the firstfive months of 1979. The rapid rise in consumer prices appears tohave hastened the downturn in final demands. The economy has shownlittle growth since last winter, and many forecasters believe theUnited States is already in a recession. GNP data for the secondquarter are not yet available, but a sharp decline in real finalsales is likely. Output probably exceeded sales so that a buildupof inventories may have limited the impact of the decline on totalreal growth. Although the future path of output is highly un-certain, CBO believes that the most likely outcome is a significantdecline in real activity during 1979 and, following some moderationof inflation, a weak recovery in 1980.

RECENT POLICY DEVELOPMENTS

Both monetary and fiscal policy have shifted in a restrictivedirection during the past year, contributing to the economicslowdown. Such policy shifts affect real activity much earlierthan they affect prices. The response of monetary and fiscalpolicy to current developments will play an important role in thecourse of the economy over the forecast period.

Federal Fiscal Policy

In accordance with its desire for fiscal restraint in orderto control inflation, the Congress now plans a reduction in therate of increase in federal spending in fiscal year 1980. Thefirst concurrent budget resolution for fiscal year 1980 calls foroutlays of $532 billion, only 7.6 percent above the 1979 resolutionfigure (see Table 13). The budget resolution included both no taxcut and a $10 billion decline in the federal deficit, to a $23billion level in 1980. The projected deficits for fiscal years1979 and 1980 are considerably smaller than those recorded in thethree preceding fiscal years, when the deficits totaled $66.4billion, $45.0 billion, and $48.8 billion, respectively.

31

TABLE 13. FEDERAL BUDGET ESTIMATES UNDER CURRENT POLICY ASSUMP-TIONS, FISCAL YEARS 1978-1980: IN BILLIONS OF DOLLARS

1979 1980SecondBudget CBO First CBO

1978 Resolution Forecast Budget Forecast(actual) Revised Assumption Resolution Assumption

Receipts

Outlays(PercentChange)

Deficit

402.0

450.8

(12.2)

48.8

461

494.45

(9.6)

33.45

467

495

(9.8)

28

509

532

(7.6)

23

519

540

(9.1)

21

CBO's forecast assumptions for the federal budget, also shownin Table 13, call for higher revenues than specified for the latestbudget resolution, primarily reflecting an unexpectedly high levelof personal income tax collections so far this year. CBO's outlayassumptions now include an $8.0 billion overrun in spending infiscal year 1980 relative to the first concurrent resolution. Theoverrun reflects higher estimates of outlays for national defense,interest, and various transfer payments such as unemploymentinsurance and Social Security. Largely as a result of higherdefense procurement outlays, spending in the current fiscal year isalso expected to exceed the target of the second concurrent reso-lution for fiscal year 1979. These projected overruns contrastwith, the shortfalls experienced earlier with the new budgetprocess. I/

_!/ Throughout the history of the new budget process, actualspending levels have been below the levels specified in thebudget resolutions. The earlier shortfalls in spending (rela-tive to the final budget resolutions) amounted to $10.1 billionin fiscal year 1976, $7.8 billion in the transition quarter(July 1 through September 30, 1976), $7.3 billion in fiscalyear 1977, and $8.4 billion in fiscal year 1978.

32

The Fiscal Policy Impact on the Economy. The federal budgetrecently has become restrictive in its impact on the economy.The growth in federal expenditures during the first half of1979 has been considerably less than the rate of inflation.The stimulative impact of the $13 billion cut in personal incometaxes last January has been offset by increased Social Securitytaxes and fiscal drag—the increase in effective tax rates broughtabout by the interaction of the progressive tax structure andnominal income growth. The reduction in business taxes lastJanuary, amounting to about $6 billion at annual rates and mainlyreflecting a reduction in corporate income tax rates, is notexpected to have a major effect on the economy during its firstyear of enactment.

Given current policy budget assumptions, fiscal policy shiftssharply toward restraint in the projected period. As shown inTable 14, the full-employment budget swings toward surplus bynearly $54 billion from fiscal year 1978 to fiscal year 1980.The projected movement toward restraint is attributable to a

TABLE 14. FEDERAL DEFICITS AND FULL-EMPLOYMENT BUDGET MEASURES,FISCAL YEARS 1977-1980: IN BILLIONS OF DOLLARS, NIABASIS

Full-Change in Employ-

Federal Full-Employ- mentFiscal Deficit ment Deficit Expendi-Year (NIA basis) or Surplus tures

Full-Employ-ment

Ratio ofFull-EmploymentSpending toPotential GNP

Receipts (percent)

1977

1978

1979

1980

-46.7

-36.8

-22.6

-16.9

+4.9

+4.1

+20.3

+33.6

401.4

446.0

492.7

530.2

392.7

441.4

508.3

579.4

20.6

20.7

20.3

19.3

SOURCES: Historical data—U.S. Department of Commerce, Bureau ofEconomic Analysis. Projected and full-employment data—Congressional Budget Office.

33

rapid growth in personal income taxes measured at full-employmentlevels, and to reduced growth in spending. The slower growth inspending is reflected in the ratio of full-employment expendituresto potential GNP, which is projected (on a current policy basis) todecline to 19.3 percent by fiscal year 1980, more than a fullpercentage point below the rate experienced in the 1977-1978period.

The changing composition of federal spending also suggestsless fiscal stimulus. In fiscal years 1979 and 1980, federalpurchases and grants are expected to decline as a percent of totalexpenditures (NIA basis), while interest payments and transfers topersons increase (see Table 15). Since purchases are believed tohave a quicker and larger impact on the economy than most otherforms of outlays, this compositional change in the budget will tendto reduce its overall impact.

TABLE 15. TRENDS IN THE GROWTH OF FEDERAL SPENDING AND ITS COMPOSITION, FISCALYEARS 1976-1980: IN BILLIONS OF DOLLARS, NIA BASIS

1976 1977 1978 1979 a/ 1980 a/

Federal ExpendituresPurchasesTransfers to PersonsGrants to States andLocal Governments

Net Interest PaymentsOther b/

Federa.l Spending as aPercentage of GNP

371.5126.2153.5

57.525.29.1

22.9

412.0140.7166.4

66.228.410.3

22.5

450.6151.1178.4

74.633.712.8

22.1

496.3164.7198.6

77.940.614.5

21.7

544.6177.5227.3

79.944.515.4

21.8

Budget Components as a Percentage of Total Federal Spending

PurchasesTransfers to PersonsGrants to States andLocal Governments

Net Interest PaymentsOther b/

34.041.3

15.56.82.4

34.240.4

16.16.92.5

33.539.6

16.67.52.8

33.240.0

15.78.22.9

32.641.7

14.78.22.8

a/ Fiscal year estimates are averages of the quarterly CBO forecast assumptions.

b/ Includes transfers to foreigners, subsidies less current surpluses of govern-ment enterprises, and wage accruals less disbursements.

SOURCES: Historical data—U.S. Department of Commerce, Bureau of Economic Analy-sis. Projected data—Congressional Budget Office.

34

Monetary Policy and Financial Developments

The tightening of monetary policy in 1978—including a. full3 percentage point rise in the key federal funds rate over theApril-December period—was a major element in CBO's earlier fore-cast of a downturn in late 1979. That forecast assumed that thegrowth in the broadly defined money aggregate, M2, would be at theupper end of the Federal Reserve target range during the first; halfof 1979 and that the Federal Reserve would continue to raiseinterest rates gradually through the first half of the year. Infact, money aggregate growth has been very weak for most of thisperiod, while the Federal Reserve has maintained the federal fundsrate within 1/4 percentage point of the 10 percent level achievedin the last quarter of 1978. Thus, by one measure (money aggre-gates) monetary policy was tighter than forecast by CBO, while byanother measure (interest rates) it was easier than expected.

Although interest rate behavior and money aggregate growthhave been different than assumed, the effect of monetary policyon the economy seems to have been nearly as expected. Housingstarts in particular appear to have reacted to high mortgagerates and reduced availability of funds. However, the weakness inthe economy during the first half of 1979 occurred sooner thanexpected, hastened as well as deepened by factors other thanmonetary policy—adverse weather, the gasoline shortage, and theinflation-related decline in real incomes.

Recent Money Growth—What Does It Mean? Over the period fromOctober 1978 to May 1979, the narrowly defined money stock, Ml, andthe more broadly defined money stock, M2, grew annual rates of1.6 percent and 4.7 percent, respectively (see Table 16). Incontrast, for the first three quarters of 1978, Ml and M2 grew atrates higher than 8 percent a year. This was one of the sharpestdecelerations in money growth in the postwar period. Sharp re-ductions in money growth, particularly when corrected for infla-tion, have been quite reliable leading indicators of recessions inthe past.

Some analysts and policymakers believe, however, that thisparticular deceleration is of less macroeconomic significancethan previous ones. In their view, this slowing has been caused bya voluntary shift of funds out of demand deposits into interest-bearing, but otherwise close, substitutes for money. They point tosuch recent financial market developments as negotiable order ofwithdrawal (NOW) accounts in New York and New England, credit unionshare drafts, telephone transfers between demand and savings

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TABLE 16. INTEREST RATES AND ANNUAL GROWTH RATES OF SELECTEDMONETARY AGGREGATES, CALENDAR YEARS 1976-1979

Interest Rates

Annual Rate of Growth Corporate

1976:11976:21976:31976:4

1977:11977:21977:31977:4

1978;:!1978:21978::31978:4

1979:11979:2

Ml a./

4.76.54.27.7

7.67.68.97.5

6.99.58.14.2

-2.1N.A.

M2 b/

10.910.39.113.2

11.49.310.48.1

7.28.710.17.8

1.8N.A.

AAA Bonds

8.568.538.468.18

8.038.017.958.10

8.458.678.759.03

9.299.39

ConventionalMortgages forNew Homes

8.958.939.029.07

9.008.969.029.08

9.209.389.679.91

10.2310.48 (May)

FederalFundsRate

4.835.205.284.88

4.665.165.826.51

6.767.288.109.58

10.0710.18

October1978thruMay1979 1.6 4.7

a/ Ml: Coin, currency, and demand deposits held by the nonbankpublic; seasonally adjusted data.

b/ M2: Ml plus time and savings deposits at commercial banksother than negotiable certificates of deposit issued in denomi-nations of $100,000 or more; seasonally adjusted data.

SOURCES: Board of Governors of the Federal Reserve System; Moody'sInvestor Services; Federal Home Loan Bank Board.

36

deposits, six-month money market certificates (MMC's), automatictransfer services (ATS) from savings to transaction accounts, andmoney market mutual funds (MMMF's). If these changes induceholders of demand deposits to economize on their money holdings butto behave in all other respects as if they were still holdingmoney, the monetary deceleration may not signal a reductionin aggregate demand.

Without doubt, these regulatory and institutional changes havehad some effect on the observed growth of money aggregates duringthe past year. Nevertheless, in view of the timing of thesechanges, the behavior of other money aggregate measures, and thefact that some of the new instruments are not close substitutes formoney, CBO's judgment is that the monetary slowing was an importantsign of the anticipated decline in economic activity.

Credit Conditions. Although record high interest rates haveundoubtedly had a significant impact on the economy, the avail-ability of consumer installment credit and business loans does notappear to have been severely restricted before April of this year.In regard to housing finance, the six-month MMC's, introduced inJune 1978, were widely credited with having insulated the housingmarket from monetary stringency. Because savers were permitted arate on MMC's equal to the Treasury bill rate, incentives werelacking for savers to switch their funds from mortgage-financingthrifts to the money market.

In March of this year, however, the federal financial regula-tory agencies made several changes in the rules governing the issueof MMC's. First, compounding of interest on these instruments wasprohibited. Second, the 1/4 percentage point differential on MMC'sbetween thrifts and banks was eliminated for periods when theTreasury bill rate is above 9 percent. 2/ Partly as a result

2J Before the rule change, savings banks, savings and loanassociations, and credit unions were permitted to pay 1/4percentage point above the bill rate, while banks were re-stricted to the rate itself. On MMC's issued after March 15,thrifts are also subject to the ceiling of the actual bill ratewhen that rate is above 9 percent. The effect of these rulechanges was to reduce marginally the attractiveness of MMC's ingeneral and of thrift-issued MMC's in particular.

37

of this regulatory change, commercial banks immediately began tocapture a larger proportion of deposits in the form of six-monthcertificates. Net savings inflows at thrift institutions in theApril-May period were weak, although all of the decline cannot beattributed to the regulatory change. Some forecasters expect thatcontinued high money market rates and institutional limits on theability of thrifts to offer competitive rates will cause themortgage market to tighten further.

THE CBO FORECAST

The CBO forecast, summarized in Table 17, calls for realactivity to decline in the second half of this year. Growth in realGNP over the four quarters of 1979 is projected to be in the rangeof from 0 to minus 2 percent—one of the milder postwar reces-sions. Despite an expected deceleration in the rate of increase ofthe Consumer Price Index during the second half of this year,consumer prices are expected to rise from 9.9 to 11.9 percent overthe four quarters of 1979. Reflecting the weakness in real acti-vity, the unemployment rate will rise slowly through the year,reaching the 6.4 to 7.4 percent range by the fourth quarter.

In 1980, real activity is projected to advance at a rate offrom 1.9 to 3.9 percent—by historical standards, a weak recovery.Inflation is projected to decelerate slightly to a range of from7.9 to 9.9 percent in 1980. The projected rebound in economicactivity is weak, however, and the unemployment rate is expectedto rise further in early 1980, remaining above 7 percent throughthe end of the year.

Basic Assumptions of the Forecast

Policy Assumptions. The CBO forecast is based on the follow-ing assumptions about monetary and fiscal policy over the forecastperiod:

o Current policy outlays of $495 billion in fiscal year 1979and $540 billion in fiscal year 1980; no tax law changesother than those included in the first budget resolution.

o Monetary policy remaining relatively restrictive through1979, with interest rates declining as a result of weakdemands. A shift to easier monetary policy is assumedthereafter in response to rising unemployment rates.

38

TABLE 17. ECONOMIC PROJECTIONS BASED ON CURRENT POLICY, CALENDAR YEARS 1979 AND 1980

Economic Variable1978:4(actual)

Levels

1979:4 1980:4

Rate of Change (percent)

1977:4to 1978:4(actual)

1978:4to 1979:4

1979:4to 19890:4

GNP (billions ofcurrent dollars)

Real GNP (billions of1972 dollars)

General Price Index(GNP deflator,1972=100)

Consumer Price Index(1967=100)

Unemployment Rate(percent)

2215

1415

157

202

5.8

2351 to 2443 2584 to 2789

1386 to 1415 1412 to 1469

170 to 173 183 to 190

222 to 226 240 to 249

6.4 to 7.4 6.7 to 7.7

13.1 6.2 to 10.3 9.9 to 14.1

4.4 -2.0 to 0.0 1.9 to 3.9

3.3 8.4 to 10.4 7.9 to 9.9

9.0 9.9 to 11.9 7.9 to 9.9

The easing of monetary policy is assumed to involve an in-crease in the M2 target range. This reflects testimony of ChairmanMiller that it would be preferable to increase money aggregategrowth in response to a recession rather than enact stimulativefiscal measures. 3/

Food and Energy Assumptions. The outlook for food and energyprices, while subject to a good deal of uncertainty, is neverthe-less an important component in the forecast. The food componentof retail prices is expected to rise nearly 11 percent over thefour quarters of 1979 and at an 8 percent rate in 1980. The energycomponent of the Consumer Price Index is expected to rise by about30 percent over the four quarters of 1979 and at a 12 to 15 percentpace in 1980.

The Reasons for the Downturn

The persistence and recent acceleration of inflation inducedby supply conditions is at the heart of the forecast downturn inthe economy. Such inflation reduces the real income and wealth ofconsumers and, in combination with restrictive fiscal and monetarypolicies, provides a severe drag on economic activity.

Consumer Pessimism. Indeed, the recent evidence suggests thatthe support provided by consumers in this long period of growth mayhave already come to an end.

o Real disposable income, after adjustment for the growth inemployment, turned down in the first quarter—despite thetax cut—and is not expected to increase in the secondquarter.

o Consumer surveys suggest that consumers have reduced"advance" buying of durable goods as a hedge againstfuture inflation. This may reflect reduced income growth

_3_/ See Statement of Honorable G. William Miller, Chairman, Boardof Governors, Federal Reserve System, in Outlook and BudgetLevels for Fiscal Years 1979 and 1980, Part I, Hearings beforethe House Committee on the Budget, 96:1 (1979), p. 35; andFirst Concurrent Resolution on the Budget—Fiscal Year 1980,Volume I, Hearings before the Senate Committee on the Budget,96:1 (1979), p. 175.

40

as well as the fact that price increases for durable goodshave not kept pace with the overall rate of inflation.

o The rapid rise in gasoline prices at the pump and the longlines in some areas have damaged consumer confidence andweakened the demand for larger new domestic autos.

o The demand for housing has already weakened, reflectinghistorically high mortgage rates and some tightening ofcredit availability.

o Some consumers will reduce borrowing and repay debtsas the weakness in the economy becomes apparent.

CBO expects that the weakness in household demands will resultin an unintended buildup in inventories, followed by modest cutsin production and employment.

Interest Rates. Assuming that the projected downturn is mildand inflation remains high, the downward pressures on interestrates from weakened credit demands will not be very large. More-over, because inflation will still be a problem for policymakers,it is unlikely that the Federal Reserve's target interest rate (thefederal funds rate) will be reduced sharply before unemploymentreaches high levels. Also, the program to support the foreignexchange value of the dollar announced last October implies adesire to keep rates high relative to interest rates in othercountries in order to discourage capital outflows and encourageinflows.

The CBO forecast considers current interest rates to be atpeak levels and expects some gradual easing of credit conditionsover the balance of 1979 and into early 1980. This drop is ex-pected to amount to nearly 150 basis points for most short-terminterest rates and nearly 50 basis points for longer-term rates.

The Persistence of Inflation and Its Impact on Wages andIncomes. As discussed earlier, the rate of inflation is expectedto decelerate somewhat in the second half of this year from itspresent pace. Some slowdown in food prices is anticipated thisyear, and the weakness of the economy is expected to take somesteam out of prices. In 1980, no food and energy "shocks" areassumed, although energy prices are expected to continue to risefaster than the overall rate of inflation. The scheduled increasesin the minimum wage and in Social Security taxes are smaller in1980 than they were in 1979—taking some upward pressure off

41

wages and compensation. Finally, productivity, after performingpoorly throughout 1979, is expected to rebound somewhat as growthresumes in 1980. All of these factors should help to lessen someof the upward pressure in prices in 1980. Gains in compensation,however, will remain at near double-digit rates as wage earnersattempt to catch up for the deterioration of real income growthbrought about by inflation.

The Reasons for the Recovery in 1980

The basic reasons for the recovery are the following:

o Business management of inventories has been cautiousin recent years and the current slowdown in final demandshould lead to a quick correction, which will end bythe end of 1980;

o The rate of inflation is expected to decelerate in thesecond half of 1979—setting the stage for a recoveryin real incomes—and to slow slightly further in 1980;

o Interest rates have peaked at current levels and areexpected to move slowly downward into the early stage ofthe recovery;

o Housing starts are expected to turn up in line with strongunderlying demand and improved mortgage credit conditions;

o Retail sales of durable goods should rebound after a longperiod of decline, in response to gains in residentialconstruction, replacement needs, and improvement in infla-tion;

o Despite the slowdown in the domestic economy, the demandfor exports should remain strong throughout 1980 because ofthe relative strength of the economies of the major U.S.trading partners; and

o Monetary policy is expected to accommodate the expansion.

Uncertainties in the Forecast

There is a great deal of uncertainty in the economic outlook.But most of the uncertainty works in the direction of higher

42

inflation and weaker growth than forecast by CBO. Briefly,some of the major developments that could adversely affect theeconomy include:

o A larger than expected rise in OPEC prices, or poor farmcrops that boost consumer prices above the projectedlevels;

o Serious domestic shortages in crude oil and refined petro-leum products;

o Labor strikes later this year;

o A sharp drop in the international exchange value of thedollar;

o A more restrictive monetary policy in 1980 that preventsthe projected recovery in housing construction; and

o Reductions in employment that are as large and as difficultto explain as the increases experienced during 1978.

Some of these sources of uncertainty are discussed below.

A Significant Shortage of Crude Oil and Refined Products. Ashortage of oil remains a significant possibility. The CBOforecast assumes that, while energy prices continue to rise atmore than the overall rate of inflation throughout the forecast,shortages of either crude or refined oil products will not signi-ficantly reduce industrial output, transportation, and leisureactivities.

A shortfall in oil and related products large enough to affectthe production and transportation network of the economy would haveserious ramifications for the forecast. Shortages would lead touncertainty, disrupted production, quick jumps in prices, andstockpiling of scarce commodities.

Two private forecasting firms have estimated the impactof hypothetical shortfalls in crude oil imports using their

43

econometric models of the economy. _4_/ These studies suggest that ashortfall of oil imports on the order of 500,000 barrels a daycould reduce real GNP by around 0.5 percent in the first year,accompanied by a rise in the unemployment rate of 0.1 to 0.2percent and an increase in the Consumer Price Index of about 0.4percent. Crude oil prices are assumed to rise in response to such ashortfall. If the shortfall were to continue for a long period oftime,, the gap in imported oil would be gradually reduced by a dropin domestic demand (as the economy weakened and conservationmeasures were adopted) and by the development of alternativesources of energy (primarily coal). A very small increase indomestic oil production might also be expected.

If the shortfall were much larger than 500,000 barrels aday, however, the effect on real output, prices, and employ-ment would be much more severe. A doubling of the shortfall,say to 1 million barrels a day, would more than double the esti-mated impact on the economy because of the effects on production.

Strikes. Some analysts believe that a strike by the UnitedAuto Workers (UAW) on September 15 is likely. Both Data Resources,Inc. (DRI), and Wharton Econometric Forecasting Associates haveestimated the effect of such a strike against General Motors for 45and 90 days, respectively. The DRI estimates show real GNP lowerby 0.2 percent in the third and fourth quarters but with a speedysnap-back in 1980. The unemployment rate is estimated to rise by0.1 percent for one quarter only. The Wharton estimates differ fromthose of DRI in the fourth quarter because they assume a longerstrike. Real GNP is estimated to decline by an additional 0.9percent in the fourth quarter and the unemployment rate to increaseby 0.2 percentage points. In addition, recovery from the striketakes a little longer.

Monetary Policy. While the Federal Reserve has announced apreference for easier monetary policy rather than fiscal stimulusin dealing with a serious downturn, there is no certainty thatit will apply monetary stimulus. The authorities may decide

47 Estimates made with the Data Resources, Inc., quarterly modelappear in the February and May issues of The Data ResourcesReview. The Wharton Econometric Forecasting Associates modelwas used to estimate the effects of production cutbacks; seeCongressional Budget Office, The Economic Impact of Oil ImportReductions (December 1978).

44

to give priority to anti-inflationary policies. Moreover, if aneasier policy would threaten the exchange value of the dollar., theFederal Reserve may feel that it cannot ease monetary policy.

Employment. The strong and unanticipated growth in employmentexperienced recently adds another element of uncertainty to theforecast. Some analysts have argued that a significant part of therecent growth in employment represents labor hoarding by businessesfaced with uncertainty about the long-term outlook. If this istrue, and if the hoarding seems unnecessary, then the unemploymentrate may rise more than forecast by CBO.

IMPLICATIONS FOR FISCAL POLICY

In accordance with the desire of the Congress to reduceinflation, the budget resolution enacted last spring called for arestrictive fiscal policy in 1980. It is now evident that infla-tion is an even more serious problem and the economy already weakerthan projected before the enactment of that resolution. In thepast, the prospect of rising unemployment might have brought forthwidespread support for a tax cut or other fiscal stimulus. But inthe present situation, persistent high rates of inflation raiseserious questions about such policies. If the unemployment ratedoes not rise substantially—and there can be no assurance that itwill—fiscal stimulus would only aggravate the problem of infla-tion. There is also a risk in doing nothing; if action is delayedtoo long, the unemployment rate could rise to unacceptable levelsbefore fiscal stimulus could take effect.

Unfortunately, the future course of the economy is veryuncertain and we do not know whether unemployment will rise suf-ficiently to warrant fiscal stimulus. Given this uncertainty andthe fact that the unemployment rate has not yet begun to rise, oneoption is for the Congress and the Administration to develop acontingency budget plan that could be implemented quickly, incoordination with monetary policy, should the economic situationdeteriorate significantly.

An appropriate contingency plan would not be easy to for-mulate. First, given the high rates of inflation, the decisionconcerning what unemployment rate would call for fiscal actionnecessarily involves a value judgment, about which there would beconsiderable controversy. Second, the design of a contingencypolicy should be tailored as much as possible to the expectedduration and severity of a downturn. If, for example, there

45

is a mild recession that lasts only a few quarters and is followedby a substantial rebound, the Congress may desire to continuecurrent policy because the delayed effect of fiscal stimulus couldaggravate inflationary pressures. (The major impact on employmentand output of most types of fiscal stimulus occurs more than a yearafter implementation.) If, on the other hand, the recession drivesthe unemployment rate up to unacceptable levels for a prolongedperiod, fiscal stimulus could reduce unemployment without makinginflation significantly worse.

Lastly, the policy chosen should reflect the fact that fiscalmeasures vary in their effectiveness. Ideally, measures undertakenonly for economic stabilization would have a relatively quickeffect, would reduce both unemployment and inflation, would gene-rate a large impact on employment per dollar spent, and would notresult in a permanent increase in the size of government. Very fewmeasures satisfy such criteria. Most types of stimulus reduceunemployment but also increase inflationary pressures. CBOanalysis has indicated that a decrease in the payroll tax couldmeet the criteria of reducing both inflation and unemployment overa span of a few years. Business income tax cuts might also beeffective, though their major impact is thought to be even moredelayed.

While decisions on stabilization policy are indeed importantfor the economic outlook, monetary and fiscal policy alone may notbe adequate to deal satisfactorily with an environment of highinflation and rising unemployment. The Congress may want to placeincreased emphasis on developing longer-run policies to encourageprice stability, productivity, and economic growth.

O

46